Options Trading in Volatile Markets

The impact of recent market volatility:

Nifty ended 2021 at 17354 and gave around 24% return. It is considered to be the best year for investors since 2017. However, since the beginning of this year, markets have been quite volatile. It started the year at 17387 levels on 3^rd January 2022, moved up nearly 1000 points to 18350 levels. Post that there has been downward momentum firstly due to the new Omicron variant and now an ongoing war tension between Russia and Ukraine. From the high of 18350, Nifty made a low of 16203 and dropped 2146 points or -13.25% in zig-zag manner. See price chart below for better understanding.

High volatility in last week of Feb continues

Last 1 week has been extremely volatile. The average daily High-Low for last 5 days of February has seen Nifty move 345 points on an average. Due to such significant ups and downs, option sellers have been impacted the most. Short Sellers, who are a bit aggressive in their trading style deploying strategies like Short Straddle, Short Strangle and naked Short Puts, are the worst hit.

The premium for Nifty 16000 CE for 3^rd March 2022 expiry dropped from ₹1200 to ₹500 and rose up again above ₹800 in the next trading session. Similarly, Nifty 16200 CE dropped from ₹1050 to ₹400 and went up again above ₹600, while Nifty 16500 CE dropped from ₹750 to ₹200 and went above ₹400. All these strikes took a leap because they were close to ATM or ITM. 17000 CE dropped from ₹350 to ₹100 where it became OTM and surprisingly, even after market recovered on 25^th Feb, the premium of this call didn’t increase. This was due to the unpredictable behaviour of Implied Volatility taking a toll. See 30-minute price chart of each strike given below for detailed behaviour during last 5 trading sessions.

Where is the Problem for Traders ?

There are traders who trade without hedging and try to hedge their position after the market has shown the significant movement. During this time the hedge is ineffective because the strategy has already incurred loss. Such step would only limit the strategy from incurring further losses in case the market continues the momentum. Trading in such extreme zig-zag movements for option sellers is always a challenge.

During such high volatile days, some traders try to short naked Calls, however, the price of the Call tends to drop slowly due to offsetting nature of the Implied Volatility increase. In contrast, the Put premium tends to rise very quickly due to Vega value getting added to the premium due to increase in IV. This can be seen as a sharp increase in Put value in the chart below. Soon after that, there was a sharp drop in Put premium because of two reasons: One due to the recovery in the market, and other due to drop in Implied Volatility. Nifty’s Volatility on 24^th Feb 2022 went up to 27% from 22.05% and then dropped to 24% on 25^th Feb 2022.

Another surprising behaviour observed in the chart is that when the markets continued recovering till 28^th Feb where it closed at 16793, the Put premium didn’t fall in tandem. This was again due to the unpredictable behaviour of Implied Volatility. The offsetting behaviour of IV helped Put premium from declining any further. Understanding IVs is important while trading. Implied volatility is the present volatility implying the behaviour of the market. In simple words, it is the market movement expected irrespective of the direction normally shown as percentage value on an annual basis.

What is India VIX?

India VIX or India Volatile Index is the term used by NSE to measure the market volatility. Volatility is the continuous price fluctualtion or the rate of change of price of a stock. This measurement of change in price is associated with market risk and it is sometimes referred to as fear gauge by investors. The concept of VIX was first introduced by Chicago Board of Exchange and later Indian exchanges adopted it to gauge the perception of market for next 30 days. It is calculated by using order book of the Index options which is derived using complex mathematical equations used in Black-Scholes model and it is shown in percentage terms. It is calculated using Bid-Ask quotes of the near month and next month NIFTY Options contracts. The detailed calculation of India VIX is complex in nature and it require separate blog article of its own.

Why India VIX is important?

India VIX is important because it gives perception of the market for next 30 days and thus investors can take appropriate action for their existing and future investments. India VIX and Nifty is considered to have an inverse relationship with each other. Whenever there is an increased fear in the market, the investors start selling due to panic and as a result India VIX increases. When the market stabilises or when it is less volatile, you can see India VIX falling. See comparison Chart for India VIX and NIFTY below to give a sense of their Inverse relationship.

So, what is Hedging?

Hedging essentially a means to limit risk. It is a way to protect a portfolio or an options position.  Hedge funds, mutual funds, HNI traders and veteran derivatives trader who have been investing in market for a long time and would like to keep doing so for many more years, deploy various hedging techniques to suit their investment requirements as opposed to naked buying or selling of Stocks, Futures and Options. There are various standard strategies available in the market like, Bull or Bear Spread, Iron Condor, Butterfly, Calendar spreads, Covered Call/Put and much more. It involves multi-leg strategies where a trader takes an opposing position to the actual exposure in the market to reduce the risk. It acts as an insurance for our portfolio just like the insurance we have for our cars and ourselves to protect us from the adverse events in our life.

Why hedging is important?

Hedging is a strategic tool used by highly sophisticated players in the market who understand the importance of risk management.

• Hedging provides firms or individual a unique differentiation in highly competitive environment.
• When managed efficiently, it gives trader an edge to generate consistent income without taking significant risks.
• Hedging helps a trader to manage the volatility of MTM (Mark to Market) cash flows during adverse market conditions.
• It gives clear picture of the portfolio risk.
• It helps define the risk appetite of a trader.
• It encourages a trader to gradually increase their investment and profitability.

I am a trader with small fund, how can I hedge ?

Around June 2020, SEBI introduced a margin framework which helps traders avail the reduced margin benefit by building a hedged position in F&O segment. In simple words, if a trader takes a position and hedges it with another offsetting position, the total margin required to take the position drastically reduces. Sometimes it reduces by nearly two-thirds depending upon the strategy deployed.

In ICICIdirect account you can use Pay-off Analyzer and Basket Order to form a strategy and view required margin and final reduced margin benefit for the strategy. To give you a perspective, let’s go through few examples with trading screen from ICICI direct account.

Example 1: Simple Naked Sell Nifty

In this example, suppose a trader is having a bearish view of the market and he sells 16700 Nifty CE with 3^rd March Expiry Date. You can see in Basket Order that the required margin is 112,417.40 which for a small trader is big amount. Let’s look at hedged example with two legs option strategy.

Example 2: Simple Bear Call Spread having two legs of options contracts.

Suppose a trader has a bearish view of the market and deploys a Bear Call Spread strategy by Selling Nifty 16700 CE and Buying 16800 CE. In Payoff Analyzer, a trader can check the maximum profit and loss and breakeven point of the strategy for today’s pay-off and Expiry Day pay-off. In Basket Order you can see that the margin required is ₹122,789.90 and the final margin required due to hedge is ₹32,520.40. A whopping ₹90,269 reduction in margin or 74% margin benefit applied! This is a significant reduction for traders with small capital in their account. Let’s also look at 4 legged iron condor strategy where some traders have misconception that huge margin will be required to trade. 

Example 3: Iron Condor with 4 Legs options strategy

Suppose a more experienced trader wants to trade a complex strategy like Iron Condor with a neutral view of the market. He Sells 16800 CE and Buys 16700 CE (which is also called Bear Call Spread). Similarly, he sells 16600 PE and buys 16500 PE (which is also called as Bull Put Spread). In this strategy, the required margin is ₹223,053.80 and the final margin required is ₹55,681.30.  A margin reduction of ₹167,372.50 or 75% benefit of margin due to hedge on both sides of Call and Put!

Margin Summary:

From the summary table, you can see that a significant drop of nearly 75% margin benefit is received by a trader who hedges the position.

How to trade in such high Volatile market?

As explained at the beginning of this article, risk management is the key to options trading. Creating a hedge before the initiating the trade is most important, and not after entering the trade. Hedge comes at a cost as it lowers profits, but protects downside, which is most critical. As they say in Option selling 1 loss can drown 10 gains!

Disclaimer:

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